COLUMN-As money men pile into aluminium, mind the Shanghai gap: Andy Home

LONDON, April 7 (Reuters) - Aluminium has been the best performer among the core industrial metals traded on the London Metal Exchange (LME) so far this year.

Currently trading around the $1,945 per tonne level, aluminium for three-month delivery is up 15 percent since the start of January.

LME stocks are falling at a fast pace and physical premiums are rising, although as ever with aluminium appearances can be slightly deceptive.

China's threat to force production capacity off-line over the winter heating season, starting around the middle of November, has upended a narrative of chronic oversupply.

There's still plenty of devil in the detail of what that will actually mean in seven months' time but there's no doubt the possibility of significant cutbacks has galvanized the previous underperformer of the LME complex.

No wonder the money men have been drawn into the action. Fund positioning on the LME aluminium contract is the longest it's been since the exchange first started publishing its Commitments of Traders Report (COTR) in July 2014.

That new-found enthusiasm for aluminium, however, has opened up a gap between London and Shanghai prices. The question now is how much Chinese metal might flow out through that export window.

Because while production cuts are still on the medium-term horizon, China right now is showing every sign of lifting run-rates with an accompanying surge of metal availability.

MONEY MEN ARRIVE

The most recent LME COTR shows money managers holding a net long position of 203,550 lots as of Thursday, March 30.

It represents the highest level of long positioning by fund managers since the LME introduced its report in 2014.

Expressed as a percentage of total open interest, the position was equivalent to 21.9 percent, also a record high level.

The LME COTR is not everyone's favourite data series, given some well-flagged issues with how positions are allocated between categories.

But it broadly corresponds with an alternative assessment of speculative positioning published by LME broker Marex Spectron.

Marex estimates that funds were long to the tune of 215,000 lots, representing 41 percent of open interest, on the same day. That was close to a multi-year peak of 43 percent on March 2, 2017, it said.

Slightly different numbers but the message is the same. Funds have been building length in aluminium since the start of the year.

So far they have had no reason to trim their bets on higher prices.

In broad-brush terms, three-month aluminium has made steady upwards progress over the last few months, helped by sizeable activity on upside call options and a conspicuous lack of contrarian selling.

MIND THE GAP

The problem, though, is that the funds' exuberance has helped open up a gap with the Shanghai market.

While LME prices have risen by over 15 percent since January, the most actively traded contract on the Shanghai Futures Exchange (ShFE) has lagged behind with a more modest gain of just under 10 percent.

As a result the arbitrage window between the two markets is flexing wider.

That brings with it the threat of accelerated exports of semi-manufactured products.

Product exports in January and February were relatively subdued at 580,000 tonnes, down 1.5 percent on 2016.

That may have reflected the disruptive effect of China's Lunar New Year holidays as well as shifts in the product mix below the headlines.

There is the potential for a strong pick-up over the coming months.

Because while the market is fixated on the potential for Chinese cutbacks later this year, in the very short term there is no shortage of aluminium in the country.

There is a lot of noise in Chinese production figures around this time of year but the underlying trend is firmly upwards with national output rising by an annualised 925,000 tonnes over the November 2016-February 2017 period.

More is expected to come online in the new production hub that is the northwestern province of Xinjiang, while those producers that are in the firing line for winter cuts can reasonably be expected to maximise output just as much as they can in the intervening period.

ShFE stocks were looking depleted in the fourth quarter of last year but have rapidly rebuilt over the last few months.

They currently stand at 339,691 tonnes, up 238,969 tonnes since the start of January.

None of that metal can be exported without incurring the 15-percent tax on unwrought aluminium.

Products, on the other hand, are not only untaxed when leaving the country but qualify for a VAT rebate, which is why they have historically served as the release valve for domestic market surplus.

How much product is available for outbound shipment is dependent on several variables, not least the state of China's own usage, but the surge in availability of primary metal is a somewhat ominous sign.

STRUCTURAL IMBALANCES

The rest of the world needs Chinese exports.

There is little doubt that the market outside of China is transitioning to a state of supply shortfall.

China itself is still structured the other way round with a natural tendency towards overproduction and surplus.

The flow of metal between the two in the form of Chinese products is the balancing mechanism.

But the speed of flow is determined first and foremost by the arbitrage between London and Shanghai. That arbitrage is moving to a level were exports should accelerate strongly in the coming months.

Whether they do or not is going to be an interesting test of the state of the Chinese domestic market.

An even more interesting test will come in November, when we get to see whether Beijing's war on pollution translates into a war on aluminium.

Before then, though, it's probably going to be business as usual, namely higher production and higher exports.

Funds betting on Chinese tightness later in the year may have to weather a potential storm of Chinese glut beforehand.